Photo Credit: elycefeliz

Photo Credit: elycefeliz || Duck, it’s a financial crisis! ūüėČ


Should a credit¬†analyst care about financial¬†leverage? ¬†Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts. ¬†What about operating leverage? ¬†Should the credit¬†analyst care? ¬†Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs. ¬†Changes in demand don’t affect a firm as much if they have low operating leverage.

That might be fine for industrials and utilities, but what about financials? ¬†Aren’t financials different? ¬†Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.

A simple example would be two groups of corporate bonds — ¬†one can argue over new classes of bond¬†ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.

As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.

Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators.  They all do the same sorts of analyses using similar underlying theory, though the details vary.

Regulators typically codify their analyses through what they call risk-based capital. ¬†Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent? ¬†Along with this usually also comes cash flow testing to make sure that¬†the financial companies can withstand runs on their capital structure.

When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses.  In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis.  (Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements.  The only failures in life and P&C insurance were small.)

Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers. ¬†If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry. ¬†Then every five years or so, adjust the regulations because as they get used, problems appear. ¬†After a while, the methods would work well. ¬†Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations. ¬†Their positions would be funded with a very small portion of money that currently goes to the FDIC.

This would be a very good system for avoiding excessive financial risk.  Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk.  All banks would face a simple 10% leverage ratio regardless of how risky their loan books are.  This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.

My main point here is that you don’t want to incent banks to write a lot of risky loans. ¬†It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.

As such, a simple leverage ratio will not cut it.  Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.

Photo Credit: Jessica Lucia

Photo Credit: Jessica Lucia¬†|| That kid was like me… always carrying and reading a lot of books.


If you knew me when I was young, you might not have liked me much. ¬†I was the know-it-all who talked a lot in the classroom, but was quieter outside of it. ¬†I loved learning. ¬†I mostly liked my teachers. ¬†I liked and I didn’t like my fellow students. ¬†If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT.  Even when young I spent my time on the adult side of the library.  The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it.  She would watch Wall Street Week, and often, I would watch it with her.  2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest. ¬†The two were the conglomerate Litton Industries, and the home electronics company¬†Magnavox. ¬†Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares. ¬†We did worse on Litton. ¬†Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss. ¬†Don’t blame my mother for any of this, though. ¬†She rarely bought highfliers, and told me that she would have picked different stocks. ¬†Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks.  There are a few things that stuck with me from that era.

1) All bonds traded at discounts. ¬†It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income. ¬†I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s. ¬†Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals ¬†in the mid-to-late ’70s. ¬†My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons. ¬†Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost. ¬†Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings. ¬†I first noticed that while reading through Value Line, and wondered how that could be maintained. ¬†The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability. ¬†Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go. ¬†I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency. ¬†Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things). ¬†Low stock and bond prices made pension plans look shaky. ¬†A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.


The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in. ¬†We are so absorbed in the zeitgeist (Spirit of the Times)¬†that we usually miss that other eras are different. ¬†We miss the possibility of turning points. ¬†We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy. ¬†Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us. ¬†(I’m listening to some Japanese rock as I write this.) ūüėČ

China will bury us.

Few people can see past the zeitgeist. ¬†Many can’t remember the past.

Should we¬†be concerned about companies not being able pay their dividends and fulfill their buybacks? ¬†Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow.  Stocks will likely fall with bonds if real interest rates rise.  And, interest rates may not rise much soon.  Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today. ¬†The stock market is at new highs, and there isn’t really a mania feel now. ¬†That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates. ¬†Those that held onto the Nifty Fifty may not have lost money, but few had the courage. ¬†Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough. ¬†I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it. ¬†As Buffett has said, (something like)¬†“We’re paid to think about things that can’t happen.

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

  • The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
  • Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order. ¬†Sovereign default used to be a large problem. ¬†It is a problem that is returning. ¬†As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement. ¬†Hopefully we don’t get a lot of wars as they did in that decade.
  • I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things. ¬†I’m flat there now. ¬†I think you almost have to be a trend follower there.
  • The yield curve will probably flatten quickly if the Fed tightens more than once more.
  • The internet and global demographics are both forces for deflationary pressure. ¬†That said, virtually the whole world has overpromised to their older populations. ¬†How that gets solved without inflation or defaults is a tough problem.
  • Stocks are somewhat overvalued, but the attitude isn’t frothy.
  • DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
  • Eventually emerging markets and their stocks will dominate over developed markets.
  • Value investing will do relatively better than growth investing for a while.

That’s all for now. ¬†You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way. ¬†The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. ūüôā



Well, I’m back in suburban Baltimore after the struggle of getting to the the center of DC and back. ¬†It takes a lot of energy to write 4000 or so words, tweet 26 times, meet new people, old friends, etc. ¬†Here are some thoughts after the sip from the firehose:

1) There was almost no media there this time. ¬†Maybe it’s all the action associated with a new president being elected. ¬†All the same, I see almost nothing on the web right now aside from the Twitter hashtag #CatoMC16¬†and my posts echoed at ValueWalk.

2) I came out of the conference thinking that I need to read three of the papers, the ones by:

  • Hanke & Sekerke — color me dull, but it finally dawned on me the potential degree to which structural regulatory change has been fighting ZIRP.
  • Jordan — his idea on how to sop up excess liquidity sounds interesting.
  • Goodspeed — I am a sucker for economic history — it broadens the categories that you think in. ¬†His presentation was very data-oriented, and I thought the methodology was clever for analyzing alternative deposit guarantee methods back in a time when the states regulated the banks. ¬†(Please bring back state regulation of banks; it works better. ¬†Many more failures, but they are all small.)

3) Jim Grant is always educational to listen to. ¬†I also appreciated O’Driscoll, Thornton, Orphanides, and Hoenig.

4) I would not invite back Spitznagel (irrelevant), Allison, Todd, and Gramm (three living in fantasyland).

5) That brings me to the fantasies of the conference as I see them.  This is what I think is true:

  • The Community Reinvestment Act [CRA] was not a big factor in the crisis, aside from the GSEs. ¬†Intelligent banks make decent CRA loans; I’ve seen it done.
  • Subprime lending was the leading edge of of bad lending on residential real estate, but regulators did not do their jobs well in supervising lending.
  • Tangible bank leverage was way too high, and was a large part of the crisis. ¬†So was a lack of liquidity from losing the wholesale funding markets, which disproportionately hit the big banks.
  • The big banks were disproportionately insolvent, though a few of them did not need more capital, like US Bancorp BB&T, and Wells Fargo. ¬†Many more small banks were insolvent also, but they weren’t big enough to move the systemic risk needle.
  • Banks are¬†a little over-regulated, but given the poor ways that they managed liquidity prior to the crisis, you can’t blame Dodd-Frank for trying to avoid that problem again.
  • The big bank stress tests are not real in the US or Europe; they exist to mollify politicians and bamboozle the public. ¬†If they ARE real, then publish the data, methods and results in detail.
  • Banks¬†need a strong risk based capital formula. ¬†The one for insurers works very well. ¬†Perhaps banks should imitate the stronger and smarter solvency regulations that insurers use. ¬†They might even find them looser than what they currently do, but be more accurate as to real risks.
  • Inverting the yield curve is¬†necessary in a fiat money system. ¬†You need to deflate and liquidate bad lending so that new lending in the next part of the credit cycle can recycle the capital to better projects.

6) That brings me to the realities of the conference as I see them.  This is what I think is true:

  • Fannie/Freddie were a large part of the crisis. ¬†Undercapitalized relative to the amount of default risk they were taking.
  • Housing prices were pushed too high as a result of too much debt getting applied to finance them. ¬†Loose monetary policy aided the creation of this debt. ¬†Falling housing prices were the main cause of the crisis, as many loans became inverted, and a slowing economy led to many losing their ability to pay their mortgages.
  • We needed a different bailout where bank stockholders lost all, and debtholders lose also, only after that should the FDIC have been tapped to protect depositors.
  • Bank solvency is important for the long run for the economy. ¬†A crisis like the last one erases a lot of the growth that would occur from looser bank regulatory policy. ¬†Things may be tight now, but once the system adjusts, growth should resume.
  • A¬†healthier economy has lower debt and less debt leverage/complexity. ¬†Debt and layered debts make an economy inherently fragile.
  • A gold standard does not increase instability, unless banks are mis-regulated for solvency.
  • The wealth effect is tiny, and the Fed should stop pretending that it does much.

7) While at Cato, I noticed the area named for¬†Rose Wilder Lane, the same Rose in the “Little House on the Prairie” books (daughter of Laura and Almonzo Wilder). ¬†She was a libertarian later in life, and knew Ayn Rand. ¬†Their pictures are near each other in Cato’s basement. ¬†Just a little trivia.

8 ) There was a lot of sympathy for the idea of not paying interest on excess reserves, and certainly not same rate as on required reserves.

That’s all.



Moderator: George Selgin¬†–¬†Director, Center for Monetary and Financial Alternatives, Cato Institute

Jerry L. Jordan –¬†Former President, Federal Reserve Bank of Cleveland

Steve Hanke –¬†Professor of Applied Economics, Johns Hopkins University

Walker F. Todd –¬†Trustee, American Institute for Economic Research

Selgin introduces the topic arguing how difficult it is to analyze things today

Jordan (get his paper)

Rules vs discretion — what are useful targets or indicators?

Buying/selling Treasuries; Fed funds targeting

Large balance sheets — no need for excess reserves. ¬†Large foreign banks buy deposits of FHLBs — positive fed funds rate.

Borrowing from the banking system — IOR, reverse repos.

Monetary base — currency plus reserves. ¬†Was close to accurate at the beginning, but not so now. ¬†When rates go up, it is a form of fiscal stimulus.

Monetary base has grown

Basel III massive cause for reserves.  Foreign banks have been reducing activity in the US.

Hanke Wrong things expected: hyperinflation, GDP growth, net private investment would soar, etc.

Money matters, and it dominates over fiscal policy

Money is a superior measure to interest rates

Divisia measures are superior — opportunity cost of converting a monetary asset into cash.

Center for Financial Stability takes care of Divisia measures.

Three measures: State money, Bank money and Nonbank private money.

State — M1 Currency, M4 T-bills

Nonbank private money — M2 Retail money funds, M3 Overnight & term repos, Institutional money funds, M4 commercial paper

Bank money — M1 Traveler’s Checks, M2 Non-interest bearing deposits. Savings Deposits, MM Dep accts, Small time deposits, M3 Large time deposits

Bank regulation has led to tight money, amid loose monetary policy w/QE.

Notes Kashkari’s recent proposal ¬†— would kill private money

Todd — have standard models failed?

Graph of Fed’s balance sheet — Assets, then shows money velocity/multiplier.

Government spending is up. ¬†QE not working, yet being adopted elsewhere. ¬†Suggests Jerry Jordan’s solution may work.

Swiss National Bank asked why the Fed is paying interest on excess reserves?  Who knows?

With no velocity and no money multiplier how does monetary policy affect GDP.

Central bank liquidity swaps are negligible now, though it was high as high as ~$600B. ¬†Should be limits on the Fed’s ability to enter into liquidity swaps.

Fed credited $558 Billion to US Treasury for a “security” at some point in the crisis. (??)

Suggests segmenting the Fed’s lending operations. ¬†Should be able to review any entity that would receive emergency funds.

Q1 Venezuelan guy — Can we trust the helicopter pilots? ¬†How to loosen bank regulations?

Hanke: Regulation important when it changes a lot. ¬†Not usually considered at monetary policy, but it is. ¬†Private money has shrunk since the crisis. ¬†Ultratight regulation plus loose policy — means relatively tight policy. ¬†Forget Basel IV and roll back Basel III.

Q2 Student at Southern Methodist University: When have central banks done it right?

Hanke: China has been an outlier by ignoring Basel — may have other effects later.

Jordan:¬†New Zealand often viewed as a successful Central Bank. ¬†Maybe Australia, Switzerland…

Q3 Joseph Marshall — How can things work well if we discourage savings?

Jordan: Savings glut = Investment glut (ex post).  Lower rates often drive savers to save more to get to a target.  Half-plus of US currency is held outside of the US.  Investment spending 10-11% of GDP.  Bailouts further consumption in bubble areas.

Q4 Gerry O’Driscoll — Todd: Blip in Treasury account balance may be drawdown in reserves. ¬†Promise to keep balance sheet constant until an exit is desired.

Jordan: Debt ceiling — large cash balance going into a debt ceiling period could be it.


Expresses gratitude to the speakers and Jim Dorn.  Incident of some Russians printing their own currency.  Top down central planning does not work, and threatens our liberties.

Now the Russians have a cryptocurrency…

Photo Credit: Frank N. Foode

Photo Credit: Frank N. Foode


Moderator: Judy Shelton –¬†Co-Director, Sound Money Project, Atlas Network

Gerald P. O‚ÄôDriscoll Jr.¬†–¬†Senior Fellow, Cato Institute

Kevin Dowd –¬†Professor of Finance and Economics, Durham University

Tyler Goodspeed –¬†Junior Fellow in Economics, University of Oxford


O’Driscoll — What CBs can’t do? They aren’t prescient. ¬†Policy discretion — results aren’t measured, and politicians blame the Fed when things go wrong, and take credit when things go right.

Politicians and Central bankers engage in “symbiotic rent-seeking.”

Fed reform would involve reducing the Fed’s scope, improving its performance and enhance¬†its accountability.

Fed should let assets roll off the balance sheet and even sell off securities on the long.

Eliminate Fed 13.3 powers to eliminate lender of last resort powers. ¬†Can’t implement a policy rule without that.

Wants to keep the regional Fed banks.

Dowd: “Money often costs too much” Ralph Waldo Emerson

John Law and money printing. ¬†Sir Robert Giffen: “Governments, when they meddle with money, are so apt to make blunders.”

Allowing people to use their money freely is often viewed with scepticism.

ZIRP is not stimulative.  It is a trap.


QE — greatest Wall Street bailout of all time.

Argues that ZIRP causes productivity to drop.  Real Private Non-residential investment has only now come back.

Can’t calibrate hedges because markets are too stable. ¬†In a crisis, that would shift.

QE has not worked in Japan.  Policy is increasingly delusional.

NIRP [negative rates] — doesn’t make sense. ¬†If it makes your brain hurt you are sane.

Must abolish cash to do NIRP.  The most vulnerable people depend on cash.  Loss of cash is a loss of civil liberty.  Bad guys use every amenity, including cash.

Helicopter money is a form of redistribution, which should belong to Congress.  End of sound money. Hyperinflation.

The most costly money is the money that is free.

Goodspeed: We all ought to read more financial history: Those sympathetic to the elimination of large institutions today will learn. ¬†Aids imagination. ¬†Gives you kind of a “control group” to work with.

Prior to 1863, the US states had a wide number of approaches.  There was public, mutual, and no insurance for deposits.  He looks at contiguous counties in different states with different insurance regimes.

They had no effect on bank failure initially. ¬†Over the long run, though, the more double liability resulted in less defaults. Public insurance — ¬†More exposure to real estate and interbank lending, and other types of opaque lending. ¬†Double liability took less risk prior to crises, but took more risk after crises, adding to system stability.

Seems to be that growth was the same across the counties with public vs double liability.

Scottish banks with unlimited liability. ¬†During a balance of payments crisis — uses an extension option against British speculators.

Upshot: Socializing losses does not work well in the long-term.


1) Benefit of QE?

Banking system bailout, nothing else

2) Ed Teryakin — what should Congress do to change the mandate of the central bank to get a better outcome?

O’Driscoll — long weak recovery; U-3 unemployment low¬†because of people who have left the labor force

3) Walker Todd — lend in a panic only on collateral of recognizable value for lender of last resort powers?

O’Driscoll: Texas S&L crisis — collateral rules get fuddled.

4) Real purpose of stress tests?

To calm the public.  The tests are bad, particularly in Europe.

5) John Flanders, Central Methodist University — Canadian experience many fewer defaults. ¬†Weren’t US banks over-regulated?

Unit banks less stable.  Law of small numbers in Canada.  But are fewer bank failures a good thing?

6) How did we end up with a central bank?  George and Martha Washington owned shares in the Bank of England.

Goodspeed: US banking has always had more failures. MD & VA tobacco planters defaulting on Scottish banks in 1772.

Dueling notions on the need for central banks with the Founding Fathers.  George Selgin tossed in a comment.

7) CPA — aren’t buybacks a waste of funds. ¬†Bernanke said there would be a wealth effect, and then spending will rise. ¬†Spending did not rise. ¬†Wealth effect is not big.

8 ) Isn’t it a bad thing that there were no Canadian bank failures — not enough risk taking? ¬†Morphed into a question on risk-based capital:

O’Driscoll: RBC is a disaster.

Goodspeed: Canada was not starved of capital.  Banks regulations can lead to their own set of problems. (DM: RBC creates its own weaknesses, but the one covering insurance in the US is pretty good.)




Hon. Phil Gramm –¬†Former Chairman, Senate Banking Committee

Mark Calabria introduces him, maybe a little over the top — some clever comments and insightful, though. ¬†Gramm didn’t come to Congress to be loved. ¬†What does Mother think of your ideas, Gramm would often ask.

Gramm: A few key points, try to be brief…

1) Most of what you know is not so — echoing Twain

Quotes a book on Monetary Policy from the 19th century.  Crisis: Obama: Greedy bankers took advantage of deregulation.

Insured commercial banks had high capital levels at the time of the crisis — 10% (DM: but look at the tangible capital ratios)

Government incented aggressive policies — highly levered with lots of Subprime mortgages as a result of CRA lending. ¬†(DM: note, I saw this in the low income tax credit business.)

2) Banks have been deregulated over the last half-century.  No, at least not on net. FIRREA, Sarbox, and many others (of course look at Gramm Leach Bliley).

Glass Steagall existed prior to the Great Depression.  Glass believed in the real bills doctrine.  No evidence for banks overdoing margin lending.  The Fed started eroding Glass Steagall prior to GLB.  The only thing GLB did was allow banks to participate in a wide number of different businesses in separate subsidiaries.  Argues that it clarified regulatory authority.

GLB made banks more stable.  Clinton saw this in diversity of revenue streams.  Argues that GLB had nothing to do with crisis.

3) Financial crisis occurred because of institutions too big to fail.  940+ institutions were bailed out.  Many large firms did not need the bailouts, and it was forced on them.  Lehman was not too big to fail.

4) The bailouts were large and costly.  S&L bailout $258B.  Depositors bailed out.  Current bailout: US Govt made $24B on the bailout.

5) What turned the crisis into the Great Recession? Obama pursued bad economic policies that overcapitalized the banks. ¬†As such the banks don’t lend, and the recovery was weak.

6) Worried about two hidden costs of Obama policies. a) run-up in the debt, which may lead to much high costs when interest rates normalize. ¬†b) explosion of the monetary base — IOER and reverse repos ameliorate, but what if we had a real recovery?

Government might find itself competing with private sector for capital then.


1) Erin Caddell, Capstone LLC — how would you modify Dodd-Frank?

He would eliminate most of it, except that banks have to take back mortgages that default early.

2) Student from Georgetown: Major headwinds for debt reduction, what will happen?

Debt reduction won’t be top priority. ¬†Doesn’t get infrastructure investment. ¬†Either get rid of Obamacare or not. ¬†There will be people that lose as deregulation if it occurs.

Likes Pence and Priebus.  (for now)

Photo Credit: Jeff Upson

Photo Credit: Jeff Upson



Moderator: Josh Zumbrun –¬†National Economics Correspondent, Wall Street Journal

Athanasios Orphanides –¬†Professor of the Practice of Global Economics and Management, MIT Sloan School of Management

H. Robert Heller –¬†Former Member, Federal Reserve Board of Governors

Daniel L. Thornton –¬†Former Vice President and Economic Advisor, Federal Reserve Bank of St. Louis

Zumbrun introduces the panel, saying they are monetary policy practitioners.

Athanasios Orphanides begins by praising Friedman, mentioning the book Monetary Mischief. (Note: Amazon Commission)

Limited space for fiscal policy given high debt levels.  Monetary and fiscal are always linked, though central bankers are loath to discuss it.  Puts up a graph of rising government debt 1998-present.  Also graphs Italy, Germany, Japan.  Is there a debt trap now?  Is there monetary mischief, inflation, now?

(DM: Phil Gramm just sat down next to me.)

Can debt be sustainable over the long run? WIll there be policies that kill growth?  Inflation is too low?  Are there policies that raise the cost of financing debt? (Financial Repression)

Japan was already experiencing deflation prior to the crisis.  ECB gets its own crisis as a result of their structure.

Puts up a graph of policy of ECB, BOJ, and Fed.  Suggests that quantitative easing was warranted, and other abnormal monetary policies.  Suggests that BOJ QE was mild until 2013.

Puts up a graph of Central Bank balance sheet sizes.  Then one of average interest rates for government debt.  Then one of real per capita GDP, suggests that Japan has not done much worse than the US, though demographics are a problem.

Comments that QE is a help to governments in financing their debts.  Look at gross debt net of central bank holdings.

ECB great for strong economies, and poor for weak economies.

Fed — should we be concerned about the balance sheet? ¬†IMFsays we can grow out of the huge balance sheet if the balance sheet does not grow.

Unsound fiscal policy overburdens central banks.

Heller: everything I want to say has been said already.  Monetary mischief: Monetary policy does not serve the nation.  Debt trap: the det grows faster than GDP inexorably.

Suggests that a 0-2% target would be better than 2% for inflation. ¬†2% consensus under Greenspan — but that is not price stability — eventually Bernanke defines 2% as price stability.

QE was ineffective, and the Fed always overestimated its value.  Limited room for future stimulus. Perverse effect on savings.  Must save more to get the same amount of future funds.  Growing income and wealth inequality.

Hyman Minsky: “Every expansion creates the seeds of its own destruction.”

Pension funds suffer and are underfunded.  Life Insurers suffer a little.  Stock market tracks QE.  The rich do well as a result.

Moving closer to a Federal Debt trap. ¬†(Guy next to me says “Kaboom” when looking at the debt graph.) ¬†Interest payments double as interest rates normalize. ¬†(DM: that’s why they won’t normalize — at least not willingly.)

Thornton: The Fed’s policies are a disaster, and they are ongoing. ¬†QE and forward guidance on long-term yields. ¬†Risk-taking is reduced, and GDP grows more slowly. ¬†No empirical support for QE. ¬†Keynesian economics have led to a credit trap.

Puts up a graph of CD rates versus t-bills. ¬†Then Baa yields minus Aaa yields — markets had stabilized by 2010 by these measures. ¬†Bernanke also argued that QE reduced term premiums, but markets are not segmented.

That said, FOMC’s low interest rate policy, helped make long rates low. ¬†As the ’90s progressed, Fed funds became uncorrelated with long Treasuries. ¬†Detrended, after May 1988, behavior changed because the FOMC used the Fed funds rate as the main policy tool, which affects short rates predominantly.

Graph with high negative correlation between the Fed funds rate and the spread between 10 and 5-year Treasury yields.  Quite striking.  (DM: this is all bond math)

Graph of household net debt as as fraction of disposable income.  New bubble of stocks plus real estate.

Argues that credit trap has been going on for 50 years or more.   Reliance on credit is evident from the growth  in government debt, which is a function of Keynesianism.


Q1 Chris Ingles, CPA: Isn’t the Fed enabling the growth of a socialist state? ¬†Isn’t growth coming from government deficits?

Orphanides says blame governments, not central banks.  CBs get forced into enabling the politicians in order to keep things stable.

Q2: Mike Mork, Mork CApital Management — wouldn’t it be better to let interest rates float to aid the market’s allocation of capital?

Thornton: Fed can’t really control interest rates. ¬†We could get out of the zero lower bond at any point by selling bonds and adjusting policy. ¬†Take away the excess reserves and the market will find its own level.

Orphanides: can use balance sheet or rates — focus on the results of price stability

Heller: Money supply prior to mid-80s under Volcker gave way to Fed funds under Greenspan.  Existence of money market funds was a reason for that.

Patricia Sands from George Mason U:  Were the central banks really surprised?  Why do Central Banks exist in the first place?

Orphanides: we want to avoid inflation via monetizing the debt.  We sometimes get second and third best solutions.  We want to avoid the worst cases.

Heller: CBs can’t bail out governments without risking hyperinflation.

Thornton: interest rates are not the solution. ¬†They don’t create big changes in spending. ¬†(DM: Yes!)

Moderator: Craig Torres –¬†Financial Reporter, Bloomberg News

John A. Allison¬†–¬†Former President and CEO, Cato Institute, and former Chairman and CEO, BB&T Bank

Mark Spitznagel –¬†President and CEO, Universa Investments, LP

James Grant –¬†Editor, Grant‚Äôs Interest Rate Observer

John Allison: Talk about Monetary vs Real economic effects.  Wall Street did not cause the crisis.  Was a combination of CRA and the GSEs, aided by the Federal Reserve.

When the dot-com bubble deflated, Greenspan ran monetary policy too loose, and deliberately inflated a housing bubble.  Greenspan (DM: Bernanke) talked about the global savings glut.  When rates rose, they rose rapidly in percentage terms rapidly.

Bernanke inverts the yield curve, incenting banks to take undue credit risk.  Bernanke said that there would be no recession amid all of the bubbles.  Many mainstream businessmen felt fooled by the Fed.

Average businessmen expect businessmen expect inflation, but it is not happening.  Now they behave conservatively.

Regulation was worse than monetary policy.  Risk-based capital. Privacy act. Sarbox.

A big deal, and I am the only one talking about it: Early ’80s: attacked bad banks and they failed — a good thing. ¬†Good banks kept operating. ¬†This time regulators saved bad banks and regulated good banks more heavily — perverse. ¬†Totally irrational.

Sheila Bair should not be viewed as a hero. ¬†Closed barn door after cow got out. ¬†Later “solutions” not useful.

Bernanke’s book: on the verge of global armageddon… JA thinks contagion was far smaller than perceived.

Liquidity requirements are restraining lending. ¬†Thinks that banks can’t aid in creating jobs. ¬†Lending standards are tight.

Likes a bill coming out that would loosen matters. ¬†Talks about the ’90s when BB&T opposed regulation on supposed racial discrimination in lending.

(DM: What a dog’s breakfast of clever and stupid)

Mark Spitznagel — management and hedging of extreme risks.

Mises — No laboratory experiments can be performed with respect to human action.

Talks about equilibria, correcting processes, etc. ¬†(DM: Loquacious, not going anywhere… boring.) ¬†Mentions Tobin’s q-ratio.

(DM: I remember that I didn’t give his book a good review. ¬†His talk validates that review.)

Tobin, a Keynesian, looked at the q-ratio as a monetary policy tool. ¬†But investment doesn’t get affected much by the q-ratio.

Shows how the q-ratio is negatively correlated with future returns, and the left tails get bigger as q-ratios get higher.

Trump can stimulate, but crashes will bring correction.

James Grant: Gruber, Obamacare founder said that it passed because the American people are stupid.

New ideas: what to do now after the election? Grant suggests older policies that existed over one century ago. ¬†Or, more modern: Taylor Rule? ¬†Friedman’s constant growth rate of money…

Monetary policy has been debated for the last 250 years… the Fed was viewed as a solution to the Money Trust, but brought its own problems. ¬†Pension fund problems…

The Fed has paid no price for its manifold failings.  Double Liability would be a better method.  Bank shareholders should bail out, not taxpayers.  Monopoliies: PhD economists w/tenure, Federal Reserve.

$15 Trillion of government bonds have been sold with negative yields.  A promise to store fiat money at a loss.

Panics used to occur at 10-year intervals, w/gold backing and double liability.  The economy grew rapidly then.

Overstone: “the trouble with money is credit, and the trouble with credit is people.”

We like being spared volatility.  How many truly want to have a Old Testament-level bear market?

Swiss National Bank? Creates francs to tamp down the currency and buys up euros, dollars, then stocks.

QE is a cautionary tale.  It failed politically because it did not work.  Failure of the PhD standard will lead to new thinking.


Mark Q1: Trump sounds monetarist, not radical.  Who will bring change?  Who will swim against the tide of Statism?

Grant: Will swim against statism.  Yeah!

Q2: Could gold trading be viewed by the US as a currency exchange? (lower taxes)

Grant: would be easy to do, but difficult to get done politically.

Q3: Isn’t the cost of funny money low productivity growth? ¬†(True everywhere it has been done)

Allison agrees.  So does Spitznagel.

Q4 Julie Smith: recent events in India — the war on cash. ¬†Comments?

Grant talks about Ken Rogoff, and remove $50 and $10 bills so that negative rates can prevail. ¬†Someone picked up a copy in India — and it will be self-destructive. ¬†It murders the cash system, which is the real banking system in India.

Q5: Alex Billy Grad Student at Georgetown: Did the Mexican crisis in 1995 have an impact on future developments?

Allison: big New York banks got bailed out of an irrational risk.  The cure for too big banks is to let them fail.  Wall Street was bailed out at the cost of Main Street.

Bert Ely Q6: Support for Basel III is sagging.  What would the effects be?

Allison: Great. ¬†Let’s just have a leverage ratio.

Me Q7:  Risk based capital vs liquidity Life insurers vs Banks?

Allison: doesn’t see it that way. ¬†Insurers are very different than Banks. ¬†Buying too much MBS at banks as a result.

Q8: “Ships are safe in harbors, but that is not what ships are for.”

Grant: agrees. Goodhart: Banking and the finance of trade in New York.  Banks had to remain liquid and well capitalized in order to survive.  It was a good system.

Q9 (Torres): What should we do now?

Allison: Modify Dodd-Frank such that bank with a 10% leverage ratio could opt out of Dodd-Frank.

Grant: How to modify the Fed: End Humphrey-Hawkins. ¬†Don’t take a poison chalice… reform wisely after there has been a real crisis and want real solutions.

Spitznagel: end low rates so that economic actors don’t take marginal risks.

Photo Credit: Shawn Honnick

Photo Credit: Shawn Honnick


Hi. For long-term readers of Aleph Blog, when I am at this Conference, there are a lot of posts. If you tire of monetary policy, or my view of it, you can leave me for a day, or, read the summary that I will write this evening.

I got here early for once, taking Google Maps’ pessimistic estimate a little too seriously. ¬†That said, I ran into more jams going early (6:40-8:10) than when I used to work in DC. ¬†In a little bit,¬†James A. Dorn,¬†Vice President for Monetary Studies at the Cato Institute should open the program. ¬†When I get spare moments, I will be tweeting at @alephblog. ¬†You can also watch the hashtag CatoMC16.

(Note: what you will get from me in the next series of posts is basically a series of my notes on what is said at the conference. ¬†I will highlight my thoughts with “DM”)

(Hey! James Grant just walked next to me.  I got to greet him.)

James Dorn is introducing the program and other affiliated programs. ¬†Mentions unconventional monetary policy — low rates, negative rates, big balance sheets for central banks. ¬†Do financial markets lead the Fed or vice-versa? ¬†How can markets play a greater role in monetary policy? (DM: perhaps those are opposed to each other.) ¬† He now introduces:

Thomas M. Hoenig —¬†Vice Chairman, Federal Deposit Insurance Corporation

Talks about monetary policy and macroprudential supervision. Suggests that policy has been too short-run focused, leading to less stability.  The dual mandate sometimes leads to short-run behavior, though it does not have to.  (DM: politics leads that.)

End of Glass-Stegall with lower levels of capital led to the crisis, with Commercial and Investment Banks seeking financial protection amid risky activities.  Monetary policy was very accommodative leading up to the crisis.  The system was more sensitive to shocks.  Central Banks and government pumped in a great deal to stem the crisis.  (DM: badly targeted)

The Fed and other central banks discovered the asset side of their balance sheets, and began to allocate credit to non-standard assets.

Macroprudential policy is touted as something to undo excesses of monetary policy, but it will not undo inequities stemming from wealth effects.

We now experience low real growth. ¬†Arguments are coming now to weaken macroprudential policy to goose growth. ¬†He argues that that would be long-run foolish. ¬†The system is fragile enough already, so don’t undo what little progress has been made to make things more stable.

(DM: mentions rising interest rates as a threat, but if banks are doing asset-liability management right, that should not be a risk.)  Argues that rates should rise at a transparent and deliberate rate.

Argues that the industry should pay out less of their earnings, and retain them as working capital, and aid in increase of lending.  The government safety net should not be an implicit subsidy to big banks.  Long-term growth will be best achieved with strong banks.


Thomas Attaberry FPA Advisors: Nonbanks are providing a lot of finance.  How do you work with that?

Banks lend to nonbanks.  We should regulate that lending.

Q2: Different capital for different classes of assets. ¬†Why can’t we change that?

Not a fan of Risk-based capital.  (DM: !) Good as internal tools, but not as an external measure.  Would simply use the leverage ratio.

Victoria Guido, Politico: How does the election change your view/practice of regulations?

He’s going to follow the law. ¬†It’s all he can do.

Guy at US Bureau Labor Statistics: What do you mean about labor normalizing?

Not sure what the guy is talking about. Finds it difficult to believe that zero interest rates for 8 years is normal. ¬†Misallocation of capital. ¬†Look at long term history — eventually move to a policy that reflects that. ¬†Will not be simple to undo zero rates. ¬†Quick? Slow?

Walker Todd, Middle TN State U: Professors talking about ETF market — isn’t this like CDOs etc. prior to the crisis.

Does not know what to say, will look at it.  (Lousy question and answer.)

Carl Golvin How can fiat money lead to a stable economy? ¬†Why can’t we go back to gold/silver — constitutional money?

There are still bank crises under gold standards.  Supports central banks with greater limits.

Max Gilman U Missouri — Mentions Bagehot and reserves held at bank of England. ¬†Why doesn’t FDIC set up a safety net for all financial institutions on a risk-based basis?

We get lobbied on all sorts of things.  We provide capital on a legislated basis.  Shareholders and bondlholders should absorb loss first and second (DM: good answer).

Photo Credit: MDV
Photo Credit: MDV || May you live to see many beautiful sunrises!


Regardless of your political point of view, life will go on after the election. ¬†Truth, given the two leading candidates, I get why many feel bad — they are both personally flawed to the degree that we shouldn’t want to entrust them with power. ¬†We all are sinners, myself included. ¬†That said, those who lead scandalous lives are unfit to lead society.

But under most conditions, cultures, economies, and governments survive bad leaders.  This is true globally.  This has been true in the US historically.

And guess what? ¬†The markets really don’t care that much about current politics. ¬†Markets in aggregate react to changes in the long-term view of economic activity. ¬†The only things that interfere with economic activity to that degree are:


  • Wars (think of the World Wars, or the Thirty or Hundred Years Wars)
  • Plague (think of the Black Death, severe as it was the influenza epidemic of 1918 was just a speed bump in comparison)
  • Famine (usually associated with severe Socialism… think of the Ukraine in 1932-33, the Great Leap Forward 1958-61, Pol Pot in Cambodia, present-day North Korea or Venezuela…¬†and there is more)


  • Changes in human fertility
  • Technological change
  • Gradual increasing willingness for people to be trusting in economic relationships, leading to investment, lending and trade on a wider scale, leading to lower costs of capital. (That included ending the teaching of Aristotle that money is sterile, which happened among Christians at the Reformation, and among Muslims in the late 20th century in some convoluted workarounds)
  • Cultural changes such as the willingness to not engage in subsistence agriculture, and trust the division of labor. ¬†Willingness to educate children (including women) rather than use them for immediate productive purposes.
  • Desire of the governing powers to wall off resources for their private use or non-use ¬†(think of governments owning huge amounts of land, and denying use of the land to most. ¬†Same for technologies¬†and resources.)

I’m sure there are things I left out, which could make for a lively conversation in the comments. ¬†But note this: in general, though the sudden events may have severe effects on economies and markets, they tend to be the most transitory. ¬†It’s the gradual changes that have the most effect in the long-run.

Also note that most of these do not get affected much by normal politics. ¬†Yes, the “one child policy” affected human fertility, but look at efforts by governments to get husbands and wives to have children and the effects are tiny at best. ¬†And even the “one child policy” is partially reversed, and I expect that it will be dropped in entire. ¬†(And then the Christians and Muslims can stop hiding their children…)

Governments can intervene in economies lightly or moderately, and people adjust. ¬†Overall productivity doesn’t change much. ¬†At severe levels of intervention, it ¬†changes a lot. ¬†Intelligent people look for the exits, even at the cost of being exiles.

Governments can go to war, and if it is small relative to a country that is involved, the effects are light. ¬†Big wars are different, and can destroy productivity for a generation, or permanently, if the culture doesn’t survive.

The Great Depression, bad it was, and loaded with policy failures of Hoover and FDR, ended in less than a generation.  The markets recovered as if it had never happened, and then some.

Are our government policies, including those of the central bank, lousy?  Yes.  WIll they get worse under Trump or Clinton?  Sure.

Things won’t likely be bad enough to derail the economy and the markets for more than a generation, so invest for the future. ¬†The Sun will rise tomorrow, Lord willing.

But, the Son of God will reign forever.



The collapse of debt fueled bubbles can only affect less than a generation. ¬†Why? ¬†They don’t affect productive capital assets, they only affect who owns them, and receives benefits from them. ¬†That is why depressions have far less effect than major wars on your home soil or major plagues. ¬†Eventually a new group of people pick up the pieces at reduced prices, and use the capital to new and better ends.